Thursday, July 3, 1997

Best Buy, Inc.
(NYSE: BBY)
Phone: 612-947-2000
Website: http://www.bestbuy.com
Price (7/3/97): $14 7/16

HOW DID IT DOUBLE?

Five years of phenomenal sales growth turned this Midwestern consumer electronics retailer into a powerhouse. Yet for over two years, Best Buy has been a bad buy for investors as the stock has been marked down repeatedly, from $44 in late 1994 to $7 7/8 in February. As already slim margins wasted away, the company's $7.8 billion in FY97 sales amounted to a measly $1.7 million in profits.

The recent drop started last September when the shares were cut in half to $12 on word of a third quarter loss. Declining same-store sales and a weak holiday selling season continued the slide. Weak January sales and worries the company might violate its loan covenants sent the shares to $7 7/8.

The rebound from there follows two estimate-beating quarters. On April 9, Best Buy reported fourth quarter results of $0.20 per share, down from $0.46 in the year-ago period. Still, that crushed analyst expectations of a break-even quarter. Same-store sales were down 11%, but a changing product mix and tighter inventory controls offered signs of life. Gross profit margins hit 13.9% versus 12.2% for the year-ago period. Then on June 18, the company reported a first quarter loss of $0.06 per share, better than the $0.10 loss per share that had been forecast. Gross profit margins rose to 15.4% from 14.2%.

The secret? Best Buy has learned from rival CIRCUIT CITY (NYSE: CC) and relinquished its casual sales approach when it comes to pitching service contracts. Warranties recently hit 2.9% of sales, nearly double year-ago levels. Last week, company officials said Best Buy could meet the high end of earnings estimates for FY98.

BUSINESS DESCRIPTION

Based in Eden Prairie, Minnesota, Best Buy is one of the nation's largest specialty retailers of name brand personal computers and home office products (39% of sales), consumer electronics (29%), entertainment software (18%), and appliances (9%). The company operates 274 stores in 32 states and plans to open 11 more stores this year after opening 21 last year.

FY97 sales of $7.78 billion matched the $7.66 billion reported by Circuit City. Unlike that company, Best Buy's salespeople don't work on commission, and its products are on the shelves ready to be carried away rather than in a back room. Both features reflect the company's pressure-free sales approach.

FINANCIAL FACTS

Income Statement
12-month sales:    $7740 million 
12-month income:   ($1.3 million)
12-month EPS:      ($0.03)
Profit Margin:        N/A 
Market Cap:        $628.9 million 

Balance Sheet
Cash:                $94.9 million
Current Assets:     $1382 million
Current Liabilities: $808.4 million 
Long-term Debt:      $212.6 million     

Ratios
Price-to-earnings:  N/A
Price-to-sales:     0.08

HOW COULD YOU HAVE FOUND THIS DOUBLE?

Spotting Best Buy's troubles shouldn't have been that hard: competition is rough when a retailer must offer extended interest-free credit to rustle up business. Declining same-store sales reflected that problem. But with such miserable earnings, surely the company was at work fixing its problems, focusing on profitability rather than revenue growth.

Success at curtailing liberal credit policies, reducing the number of new store openings, and boosting gross profit margins were all reasons for optimism. An investor looking for positive earnings surprises could have spotted Best Buy in time to gain some of the double.

WHERE TO FROM HERE?

CEO Richard Schulze said recently that he's comfortable with earnings estimates of $0.70 a share for FY98, the high side of current estimates. That puts the shares at 22 times forward estimates, reasonable even with PC sales and margins uncertain and a mass market for DVD at least a year away.

The real story here is that Best Buy is looking closely at its operations in an effort to actually turn a decent profit on its huge sales. Even the optimistic forecast for FY98 assumes the company will report net profit margins of just 0.4% versus 1.4% margins in FY94. A return to that earlier level of profitability would mean earnings of $2.50 a share!

Better inventory management should help, but service contracts offer huge possibilities. As Schultze said last week, the company intends to increase its warranty service business to 3% of sales this year from just 2% last year. Every percentage point increase equates to a $0.50 increase in EPS. With Circuit City currently generating over 5% of revenue from warranties, Best Buy appears to have room for remarkable earnings growth from service contracts alone.

Whether management can actually deliver the goods, though, is an open question, particularly given Best Buy's low-pressure sales culture.

-Louis Corrigan
(RgeSeymour@aol.com)

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